Does Today’s Farmland Market Make Sense?

1 Mark GoodwinReal Estate Broker21036 S. States LaneShorewood, IL 60404(815) 741-2226IN PERSPECTIVES pring 2012 Volume 33, No. 1 Changes in leading worldexporters of cornHistorically, the United States hasbeen the world s largest producer and exporter of corn. China hasbrought uncertainty to world corntrade, swinging from being the second-largest exporter in some years to occasionally importing significantquantities, according to the EconomicResearch Service of the of Agriculture. Argentina, the second-largest cornexporter in most years, benefits frombeing in the Southern Hemisphere. Its farmers plant after the size of corn crop is known, providing aquick, Market -oriented supply responseto short crops.

2 Several countries,including Brazil, Ukraine, Romania,and South Africa, have had significantcorn exports when crops were largeor international prices on page 2 Source: USDA, Foreign Agricultural Service, Production, Supply, and Distribution (PS&D) world exporters of corn100806040200 Million metric tonsYear1960/61 68/69 76/77 84/85 92/93 2000/01 08/09 Other China Argentina United StatesDoes Today s FarmlandMarket Make Sense? By Bruce J. SherrickProfessor of Ag and Applied Finance University of IllinoisFarmland markets in the majority of the crop producing regions of the UnitedStates have experienced exceptional price increases during the past two record-breaking prices follow a decade or more during which returnsfrom crop production have been seen as highly favorable relative to other competing financial investments and compared to commercial real estate as well.

3 To put this in perspective, Farmland values were reported to be up more than 25% from Oct. 2010 to Oct. 2011, according to the 7th Federal Reserve district which covers much of the Corn Belt. Roughly 18% increases for much of the same area for 2011 were reported by USDA sources. Similar trends were found by the Illinois Society of Farmland Managers and Rural Appraisers in their annual survey. Farmland has experienced near double digit growth for a decade running,except in 2009, and has generated 3 4% in annual income as well. This impressive upward price movement during a period of relatively stagnant but volatile financial markets has led many to question the sustainability of the current prices and whether a correction might be in the offing.

4 More than a year ago, Sheila Bair, Chairperson of the Federal DepositInsurance Corporation (FDIC), used the term bubble in comments about farmasset values. This set off a chain of related investigations by farm lenders, policymakers, and researchers. The FDIC and the Chicago Fed hosted conferenceswith cautionary titles of Don t Bet the Farm: Assessing the Boom in and Rising Farmland values: Causes and cautions. Noted Yale econ-omist Robert Shiller has indicated that Farmland is his dark horse candidate for a bubble, leading many to again question the rationality of the Farmland Market . On the flip side, incomes from crop production continue to be extremelystrong. News regarding demand for commodities has been generally routine-to-good.

5 Comparable alternative financial investments are difficult to find in manycases. In addition, institutional interest and efforts by other savvy investors in theasset class have continued to be strong. The performance of Farmland as an asset class has been documented innumerous places. Farmland investments can be fairly summarized as having lowsystematic risk and high relative returns while providing good diversification andSince NAFTA simplementation in 1994, agricultural tradewith Canada and Mexico has flourishedNAFTA - North American Free Trade : USDA, Economic Research Service using datafrom Department of Commerce, Census Bureau, Foreign Trade Statistics, as cited by USDA, ForeignAgricultural Service.

6 Global Agricultural Trade of dollarsYear1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Imports from Canada Exports to Canada Exports to Mexico Imports from Mexicopurchase-power hedging , access to constructive agri-cultural credit remains, and ag lendershave very healthy balance sheets. Ag lenders have not, in general, been chasing Farmland values upward during this period of growth withfixed loan-to-value lending practices,as some could have been described as doing in the 1980s. And, interestrates are at historically low levels andappear to be likely to remain so forsome time into the future.

7 Finally,crop insurance usage has expandedconsiderably and is considered bymost to be an essential risk mitigationtool that significantly reduces down-side income risk and allows producersto bid more efficiently for controlthrough rental markets. So, does the land Market makesense ? This simple question remains central to policymakers, investors,farmers and landowners the simple framework forevaluating the correct value of anasset. The correct value relates thereturn the asset generates incomeand capital gains to the amount aninvestor is willing to pay, a directincome capitalization argument. Theidea can be summarized as value =income/(effective capitalization rate).

8 There are nuanced arguments aboutthe growth rate, the permanence of the income, the duration of theincome and appropriate risk adjusteddiscount or cap rate to use, but in general, this model helps us tounderstand the forces driving thefarmland Market . On the income side, corn pricesaveraged approximately $ perbushel until the mid 2000s, but sincethen have varied around a higherlevel. University of Illinois professorsDarrel Good and Scott Irwin argue,and convincingly so, that a new planning price of around $ per bushel makes more sense in thecurrent environment. Farm incomeshave increased at roughly the samepace as commodity prices. Cashrents have increased as well but,actually, not quite as quickly asincomes, demonstrating a lag inrental rate adjustments.

9 In terms of the appropriate capi-talization rate, Farmland is a long-livedasset, viewed as non-depreciable, andcarries relatively low risk. The dura-tion of a typical Farmland investmentincreases its sensitivity to interestrates more so than with shorter-livedassets. In Figure 1, Farmland cashreturns are divided by Market valueand compared to the 10-year constant maturity Treasury rate perhaps a reasonable proxy for thecapitalization rate but, at minimum,an easily interpreted and constantreference to an easily understoodinstrument. Importantly, while thescale changes somewhat by location,the nature of the picture is unchangedregardless of which state s data isused in the Corn Belt and only notable divergenceoccurs in the mid 1980s during theperiod of the farm crisis.

10 Recall earlier arguments that could be summarized as rents reflect expectedincome potential,though perhapsmore smoothly and with some lag. Inthis vein, the current rent-to-income-to-value relationships do not suggestany bubble features in the Market . Converting the recent incomestream to an implied fair capitalizedvalue can also be done and providesa very similar story. Figure 2 compares the USDA average valueto capitalized USDA estimates ofrental rates over the same what seems most striking isthe similarity between actual andimplied values through all time periodsexcept the concluding that only continued prosperity lies ahead,though, it is important to appreciatethe importance of the elevated risk of capitalization rate change that is contained in the relationshipsshown in Figure appreciate this issue, considerthe final picture, Figure 3.